Four reasons one investor thinks gold could jump this year

www.marketwatch.com

For many gold traders, the only story worth following is the one about the Federal Reserve and when it will increase the benchmark interest rate.

Not so for Frank Holmes, a longtime mining fund manager who is chief executive of U.S. Global Investors and co-wrote the 2008 book “The Goldwatcher: Demystifying Gold Investing.” He currently co-manages the U.S.

Global Investors Gold and Precious Metals Fund USERX, -0.20%
In an interview with MarketWatch, Holmes said four factors — shrinking real interest rates in the U.S., a dip in the dollar that led to a so-called “death cross” formation, a jump in the global purchasing managers index and signs of increased demand from China — suggest that gold could finish the year higher, perhaps as high as $1,350 an ounce, which would be about 25% above Thursday’s close.

Today, that might be hard to fathom, as many investors are down on the precious metal, which is in its third straight down year and hasn’t closed above $1,300 since 2014. Futures prices for gold GCZ5, +0.22% have lost more than 5% this month and on Thursday settled at $1,081 an ounce for the worst finish in more than 5 years.

Gold prices have fallen about 8% from the settlement of $1,176.10 on Oct. 28, the day the U.S. Federal Reserve said it would decide whether it’s appropriate to raise the target range at its next meeting in December. The market’s estimation of the odds of a hike in December, as calculated by the CME Group FedWatch tool, jumped in response.

Higher rates — they have been near zero for years — can be a headwind for gold, which doesn’t bear interest. They can also lead to a stronger dollar DXY, +0.25% which often weighs on dollar-denominated commodities, such as gold.

Holmes, however, says he isn’t particularly preoccupied with the Fed and its plan for nominal interest rates when it comes to looking beyond short-term moves in gold. Other factors that could already influence gold’s outlook, he says, are already in play.

A gold ‘breakout’

Gold prices broke above their 200-day moving average in mid-October, briefly turning higher year to date.
That coincided with a weakening of the U.S. dollar that signaled a “death cross” — a technical term generally indicating a bearish trend that occurs when an investment’s 50-day moving average falls below its 200-day moving average, which is what happened to the U.S. ICE Dollar Index DXY, +0.25%
Commodities priced in dollars, including gold, often trade inversely with the dollar, as moves in the U.S. unit can influence the attractiveness of those commodities to holders of other currencies.

As such, a death cross for the dollar is often seen as good news for gold. There is an “80% chance gold will turn up” in such cases, Holmes said.

An eye on shrinking real interest rates

Gold hit all-time highs of $1,900 per ounce in August 2011, when real interest rates — what you get when you deduct the monthly rate of inflation from the 10-year Treasury yield TMUBMUSD10Y, +0.00% — were at negative 3%, notes Holmes. That, he said, made gold especially compelling, because investors who bought the 10-year at that time essentially lost 3% a year on a “safe” Treasury investment.

“Since gold doesn’t cost anything to hold, it became more attractive and the metal’s price soared,” said Holmes.

But real interest rates turned positive between Sept. 2011 and Sept. 2015, as inflation rates dropped, with the U.S. now having virtually no inflation, Holmes said. Real interest rates are currently at 2%. (That, he says, means there’s “no reason” for the Fed to raise interest rates, which have been unchanged since 2006, now.)

“We’ve had an invisible interest-rate rise,” said Holmes. That, coupled with low inflation, has “lately had a negative effect on gold, which means it’s even more remarkable that the precious metal broke above its 200-day moving average recently.”

But real interest rates are shrinking now, said Holmes, and if the dollar turns lower, gold could climb.

An ‘exciting’ global purchasing managers index jump

The jump in the October global purchasing managers index, a measure of the strength of the manufacturing sector, is “exciting news” that could be another sign of a move higher for gold and other commodities, Holmes said.

“Not only does this represent the strongest monthly surge in nearly two years, but the index show above it’s three-month moving average for the first time since March,” said Holmes.
In the past, according to Holmes, “the index has reliably anticipated how commodity prices might behave in later months. When a PMI “cross-above” occurs — when the monthly reading crosses above the three-month moving average — it has “signaled a possible spike in certain commodities, materials and energy,” he said.

Chinese demand expected to grow

Finally, there’s China, a demand powerhouse for a vast range of commodities that is among the world’s biggest buyers of gold.

The country has already turned to a “price maker from a price taker” as it attempts to gain more control over the pricing of gold, Holmes said. September gold imports to Hong Kong rose to around 97 metric tons from 59 metric tons in August, Holmes said.

Interest rates in China have turned negative, and the summer saw increased uncertainty in the country’s equity markets. That, Holmes said, means there’s likely to be a pickup in Chinese gold buying. Global gold demand rose in the third quarter, according to the World Gold Council.

It is “really significant” that China’s real deposit rate — the rate banks pay for deposits — turned negative again, according to Holmes, who calculates that the nominal deposit rate of 1.5% minus the CPI number of 1.6% equals negative 0.1% for September.

The People’s Bank of China recently cut its benchmark lending and deposit rates by 0.25 percentage point, sending the lending rate to 4.35% and one-year deposit rate to 1.5%. “This will cause negative real rates in China to fall even lower, which is good for gold demand,” said Holmes.

For any country that does that, “it’s bullish for gold in that country’s currency, so odds favor that they’re only going to buy more gold,” he said. “That is big.”

Gold stocks have been ‘beaten up so badly’

Given that gold prices trade nearly 9% lower year to date, it’s no surprise that gold mutual funds are poised for negative returns this year, but some have done better than others.

As of the end of October, the U.S. Global Investors’s Gold and Precious Metals Fund USERX, -0.20% is down about 0.6% this year. The Tocqueville Gold Fund TGLDX, +0.67% is down about 19% year-to-date.

U.S. Global Investors’s fund invests in shares of companies mainly involved in mining and processing of gold and other precious metals, while the Tocqueville fund invests in gold and other precious metals, as well as gold mining or processing companies.

Holmes continues to see upside in gold investments. He likes Royal Gold Inc. RGLD, +1.44% Silver Wheaton Corp. SLW, +0.32% and Franco-Nevada Corp. FNV, +0.45% — all of which have high profit margins.

He suggests a 10% portfolio investment in gold bullion and mining stocks, rebalancing every year to maintain that percentage, and continues to see an upside for gold stocks. “They’ve been beaten up so badly,” said Holmes.